Updated: Oct 7, 2020
The following trade frame is an example for educational purpose only. Please read the Disclaimer at the bottom.
When you are buying a calendar spread, you buy a longer-term option and sell a shorter-term option with the same strike. The longer-term option will cost more, thus you pay premium (debit) for this spread. Because the options have the same strike you are protected from sharp moves in the short-term and the maximum that you can lose is the premium you paid when initiating the position (also the margin requirements will be quite low).
But why would you want to get into such a spread?
If you believe that in the short-term the stock will not reach the strike, and will expire worthless, then you will have only the longer-term long option in your position, and if there is going to be a move when you only have the long option, your profits can be unlimited.
Let's look at the following example:
Astrazeneca ("AZN") is one of the companies (together with Oxford University) that have the best chance to come up with a vaccine for Covid-19. (Just for example, the Bill and Melinda Gates Foundation has contributed 750$ M towards the manufacturing and distribution a potential COVID-19 vaccine developed by Oxford & AstraZeneca).
The expected date for the vaccine is by the end of this year, early next year, according to its CEO. It should be mentioned that its phase 3 trials in the US remain halted, after one of the trial participants in the UK developed severe illnesses. But trials have resumed in England, Japan, Brazil, South Africa and India.
("I still think we are on track for having a set of data we would submit before the end of the year and then it depends how fast regulators will review it and give approval").
Now lets look at the daily chart:
We see mostly sideways price action, waiting for news on the vaccine.
So buying Call 60 for January 21 , may have a good R:R.
In order to reduce the cost of this Jan call 60 (1.85$) we can do a calendar spread by selling Call 60 for November 20. (at 0.85$) .
Because of the US election, the November skew is higher than January, although no good news are about to be announced during November.
You can see that the implied volatility is higher in the November expiration, thus these options are quite expensive.
So, under the assumption that AZN won't go over 60 until the November expiration, we can reduce the premium that we are paying for the January Calls.
Instead of paying 1.85$ , we are paying 1$ for the calendar spread.
Scenarios at the November expiration date:
AZN will go down sharply: we will lose most of the premium (although the January Calls will still be worth something. - 0.8R).
AZN will not move much: we will have Call for January that cost 1$, and if the volatility will stay the same (although it is reasonable to think it will go up) then we will break even.
AZN will go to 60 - this is the best scenario as the November call will expire worthless and we still going to hold the January Call that is going to be ATM now and trade for about 3$.
AZN will go slightly above 60 - The short-term will expire at the intrinsic value, and the long-term option will still have some time value, thus we may still breakeven, or even profit a little.
AZN will go up sharply above 70: we will lose most of the premium paid for the spread and will close the position (-0.8R). (the Jan option will trade closer to its intrinsic value).
Note that if the November option expires worthless, you are only long options now and your profit potential is theoretically unlimited. (the R:R changes dramatically in your favor).
If you believe that the stock won't reach a certain strike in the short-term, but has a chance to break through it in the long-term, then you can use calendar spreads in order to reduce your premium (your risk).
When doing so, it is important that the short term options will be expensive enough for it to be worthwhile.
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It should not be assumed that the methods, techniques, or indicators presented in this example will be profitable or that they will not result in losses. Past results are not necessarily indicative of future results. Examples presented on these sites are for educational purposes only. These set-ups are not solicitations of any order to buy or sell. We, and all affiliates assume no responsibility for your trading results. There is a high degree of risk in trading.